Wednesday, June 27. 2012
The inspiration for today’s blog post was a recent column by Reuters personal finance writer Linda Stern, looking at the current marketplace for variable annuities with living benefit riders. The article notes two of the most common concerns regarding variable annuity guarantees: they are too expensive, and there’s too much risk about whether the companies will be able to pay on those guarantees when the time comes.
These concerns are familiar ones. During research for the latest update to my book "The Advisor's Guide to Annuities" I heard many financial planners express similar worries about the high cost of variable annuity guarantees, along with fears that the annuity companies may not be able to make good on their guarantees down the road.
What Does It Mean When Annuity Guarantees Are Too Risky?
To understand why variable annuity guarantees can be risky, it’s important to understand what’s at risk in the first place, and how such guarantees operate.
In the case life insurance death benefits, the actuarial process is relatively straightforward – with a large enough number of people, the frequency of death for a group of individuals is quite easy to predict, and the companies simply pool together a large number of insureds, and let the math work for them. For instance, if 100,000 people own life insurance, it’s fairly easy to predict the amount of money that will be paid out in death benefits every year; although it’s difficult to know if any one person will pass away or not, on average the people who are still alive (and still paying premiums) support the people who died (and need to receive a death benefit), and thanks to the so-called “law of large numbers” the results average out quite reliably. Thus, in the aggregate, the insurer gathers money in the form of premiums from those who are alive each year, invests it, subtracts a small amount for expenses and the profit margins of the insurer, and pays out the remainder as a series of death benefits as people die (predictably from large numbers) each year. If mortality or investment experience are slightly better than anticipated (or expenses are lower), there is a little more money left over at the end of the year, and the insurer shows a greater profit; similarly, if investment or mortality (or expense) results are unfavorable, profits are lower. The process of annuitization operates the exact same way, but in reverse; instead of collecting premiums during life and making a payment at death, payments are made during life and cease at death.
Because the risk isn’t simply pooled – where those who live a long time support the benefits for those who die early, or vice versa – the insurance company has to manage its risk by charging a separate expense fee for the privilege of the income guarantee. If the insurance company sets an appropriate price, the ongoing reserves generated by the fees accumulate sufficiently to pay the income guarantees if/when/as they come due. If the pricing is wrong, however, then the annuity owners are at risk, as the insurance company doesn’t have enough money to pay the guarantee obligations.
What Does It Mean When Annuity Guarantees Are Too Expensive?
As noted earlier, in order to pay out annuity income (and other) guarantees, annuities must charge a fee, and often the expense can be substantial. In today’s marketplace, it’s not uncommon for annuities to have total Mortality & Expense and other income guarantee rider fees of 2% to 3% per year, before adding in the costs of the underlying investment subaccounts (roughly analogous to mutual fund fees). This is a striking total cost in a world where index mutual funds and ETFs can often be had for less than 0.20% of expenses, and even more actively managed funds might only carry a 0.75% to 1.5% expense ratio.
Of course, it’s a bit apples-to-oranges to compare mutual fund or ETF fees to the expenses of a variable annuity on a head-to-head basis, because they don’t really provide the same thing. The cost of mutual funds or ETFs simply provides access to an investment (and, perhaps, an active investment manager); variable annuities expenses, on the other hand, pay for guarantees regarding death and/or income benefits that traditional investments simply don’t offer. So it should not be surprising that separate, additional guarantees entail a separate, additional cost.
The Problem With Too Expense And Too Risky
So far, the criticisms of annuities seem relatively straightforward. The insurance companies are heavily reliant on making accurate estimates of the cost of the income guarantees that they provide; failure to estimate these costs accurately could mean, in the face of a severe bear market where suddenly the income guarantees become ‘in the money’ for almost all policyowners at once, that the annuity company simply will be unable to pay on its promises. Similarly, at a cost that may be 2 to 3 times (or more!?) the expense of a standalone mutual fund or ETF, it’s hard for many to rationalize the expense of variable annuity guarantees, even if the head-to-head comparison with traditional investments is a bit apples-to-oranges.
The fundamental problem, however, is that almost by definition, if the annuity’s expenses and fees are “too expensive”, the company should be raking in profits hand over fist… which means it should be so wildly profitable that it cannot possibly be at risk for failing to pay on its guarantees! After all, an annuity being too expense implies that the costs too high relative to the benefits that are offered, which directly contravenes the “riskiness” of annuity company guarantees which emerge when the company doesn’t charge enough for what it offers to policy owners!
Bad Anchors And Short Time Horizons
So how do we account for the common viewpoint that variable annuity guarantees are both too expensive and too risky, when in reality too much of one by definition means the opposite cannot be true as well? The culprit appears to be a combination of behavioral finance biases: bad anchors, and an excessive focus on recent (and short) time horizons.
The short time horizon problem is the tendency to extrapolate whatever is going on recently into the indefinite future, and making decisions accordingly. Thus, as markets swing from bull to bear, annuities are varyingly judged to be too expensive (during a bull market when the declines that the annuity is protecting against seem remote, suggesting the fee is too expensive) or that the guarantee is too risky (during a bear market when the declines that the annuity is protecting against are so salient, it creates worry that the annuity company will not withstand the shock). In reality, the cost of the annuity should really be judged against the entire market cycle of bull and bear markets (at least, unless the investor is specifically trying to time the annuity purchase to the market cycle and buy in when the guarantee is undervalued), not just whether the market is in the midst of a short-term bull or bear cycle.
So what do you think? Do you believe variable annuity guarantees are too expensive? Or that the companies are at risk and therefore that the annuities are too cheap and should have higher fees? How do you evaluate the costs of variable annuity guarantees? Over what time horizon? Do you have the same perspective on variable annuity guarantees and costs as your clients?
And there are companies offering these guarantees that pay no commissions at all.
The distribution channel discussion looks very much like a red herring to me.
We can also say it is too risky for the obvious reasons... companies dumped benefits and are looking to get these benefits off their books. They are telling us something by their actions. The risk to them is there; we shuold respond appropriately.
Since we can't know exactly what that is, we can guess. For example, with all the fancy ways of hedging an reinsuring coming under fire and possibly future regulation, the costs of these may skyrocket. There may be ways of heding that become so costly they can't be used, or some may even be outlawed. You can say that projections for these products was appropriate at a time, but that it is risky.
Risky actions can have a negative correlation with price, though I understand why annuities charge more of course. For example, I would want to pay less for a service that did not guarantee the outcome I wanted as much as an alternative. The poor use of the products to meet clients goals versus others makes them too risky and too expenses, though I again am not challenging your logic on the need to charge a high fees.
To me this isn't an anomaly because insurance companies are in great position to exploit consumers lack of information. Show up with a $300,000 VA death benefit payout and you have an easy on-the-spot sale for a variable annuity.
The issue of whether the value proposition is a good MATCH for the consumer is different than whether the product is overpriced.
A Mercedes probably isn't an affordable car for someone working at McDonalds. But that doesn't mean the Mercedes manufacturers are overpricing the vehicle. It simply means that the Mercedes may offer features and benefits that the McDonalds employee cannot afford to pay for.
Perhaps a better wording would have been "Annuities can't be too risky AND too overpriced"?
I'd like to see more underwriting hisotry before buying these products. Not because the cost is too high today, but because I'm not confident that the model will work when we need it to.
The point is, if you believe the VA owner is going to be "stiffed" you're implying that the annuities riders should actually be MORE expensive (1.5%? 2%? 2.5%? 3%/year?).
Of course people shouldn't do business with companies that will be insolvent. But again, that's the point. So to do business with companies that will NOT be insolvent, are you suggesting that people should only buy annuity riders that charge another 1% or 2%/year, "just in case"?
At the very least, I'd like to understand how the insurance companies offering GMIB can protect themselves from a prolonged period of bad equity returns in a low rate environment. I'm not saying it's not possible, rather that I want to see how it works. Maybe they do it with complicated derivative hedging strategies and a team of mad scientists. If that's the case sign me up! What could go wrong there?
Great work on the website. Do you have a team helping you? You seem to be pumping out information at a super-human rate. Keep up the good work!
Michael, I think it was Mark Twain who said we should only buy stocks that are going to go up - and if they are not going to go up then we should not buy them! We do not know what will happen next month let alone in 30, 40, or 50 years.
Like too many financial innovations, the risk/reward of these VA products is asymmetrical. First, many come with up-front commissions or back-end fees to the customer who has buyers' remorse, so one reward - a big chunk of revenue - is going to the insurance company today for a promise in the [often very distant] future.
A couple years ago I had to sit through a sales pitch for one of these VA products from a major firm. The salesman showed us a projection where my wife and I could roll over ALL our retirement savings into one of these products and if we never touched the money by the time we were in our late 90s we "could" "potentially" have ACUMULATED $3MM.
Please note: we are not rich, and we have no children.
This product was recently dropped by the offering company [like many other new products, for example many Long Term Care policies]. Current customers are being given another big sales pitch - no doubt for the next
big new thing - and the company would really appreciate it if you would switch! Up-front fees are guaranteed. Everything else is risk.
Annuity products of all types have not been so popular since the 1930s. Consumers afraid of stocks are buying anything else. There is a lot of fear that pensions or Social Security may not be around when it comes time to collect, so people are buying annuities [a non- company pension] that are "guaranteed" by states that are often in worse shape, financially, than the federal government.
If we continue in this low interest rate environment - for example, like Japan - for a lot longer than most people expect, I think a lot of guarantees will turn out to be worthless.
P.S. Very interesting thread! I was surprised by the very thoughtful replies on what is too often an emotional topic.
It seems to me that when many advisors say that VA riders are too expensive, it is more a statement of value than the efficacy of the insurance companies' business model. When they say it is too risky, then they are making a judgement about the business model. For me personally, no matter how cheap it was offered, I would not pay someone to mow my lawn. I mow it now for free, soon my son will be old enough to take it over, and when he is ready to leave the house I will be looking to downsize. Therefore incurring any cost for the benefit is too expensive to me. That doesn't make any judgment about whether or not the lawn mowing company can actually operate on the fee they charging, it is a statement of value.
I am unaware of ANY fixed income vehicle on the street that currently has any more ability to achieve a guaranteed income stream function VA's are offering. This is especially true when considering the monetary policy being implemented by the fed. Add to the fact that we aren't just looking at market risk, interest rate risk, or inflation risk, BUT also LONGEVITY risk as well, and the options for retirees in the "investments" world become miniscule.
Traditionally, retirement consisted of pensions, social security, and income producing fixed income investments such as bonds, CD's, money markets, etc. Two of those legs on the stool have been sawed off, so again my question is WHAT IS THE ALTERNATIVE?
Therefore, IMO, the RISKS associated to the investor of the VA becomes the only valid question on the subject IMO. The ability to deliver on the guarantee is underpinning question that must be answered by the person suggesting it, as well as the person purchasing the vehicle. The only way to know for sure is by conducting a due diligence of the VA provider company as well as any Parent Company it may fall under. That, IMO is what I would be looking for as an investor. What has my FA done in that regard, and what was the result?
The critical and prudent items to determine, again IMO are:
What is the overall health of the issuer? Credit Ratings are obvioulsy not enough, one needs to take a hard look at the balance sheets of the issuer (HOPING the books haven't been "cooked," but I digrees) and see what the situation looks like. Reserves, hedging strategy, questions about how other VA companies failed in their hedging and why ABC company is different, et all should be learned.
What is the worst case scenario? That is the question I would propose to everyone from the wholesaler, regional VP, Senior VP, CFO, to the CEO. I would have their answerers documented if not recorded. Get a feel for the strategic planning involved their risk management from WITHIN the company as well as OUTSIDE. Research analyst reports on issuing companies are available, read them!
State Guarantee programs. I would not take these at face value. Call your State Treasures office and ask for an "on the record" response on the health of these programs. If anyone hasn't noticed, 3 major municipalities in CA have filed for bankruptcy....in the same month. The financial health of our States very well could be the shoe that drops, so I would want HEAVY confirmation on the balance of the fund that would cover a bankruptcy of the issuer. Know the limits of each State are different as well.
Bankruptcy proceedings. What happens if ABC goes bankrupt? How can that happen? Would there be a like purchaser (usually is to prevent systemic risk in that industry with big carriers)? Would purchaser honor the outstanding debt obigations? What if it was the Parent Co. that went under (ex: AIG therefore Sun America - you are welcome btw, signed Joe Q. Public and The Fed)?
These are all things one must consider, the fee argument is a joke! The S&P over the last 10 years has been FLAT 0%. The 10 year treasury is almost 0%. Inflation is guestimated to be around 3% (and if you believe it is that low you probably haven't read this far anyway). Where else does the blue collar worker who retires with 300-500k in his/her 401k go? You tell me?
The point of this semi-rant/advise is to quit wasting time pointing out problems in the world (one of the many problems in today's society) and start providing solutions. That's all I got, take it or leave it.